Retroactive Reinsurance Peter Mlej November 2015

Non-Traditional forms of Reinsurance Retroactive Reinsurance Peter Mlej November 2015

Prepared by Aon Benfield

Reinsurance Market Participants

Retro Insurance Reinsurance Reinsurance Reinsurer/Ca Company Broker Company pital Markets

Main function is assessment of cedent risk, structuring, placement and administration of reinsurance treaty 1. Brokers negotiate/discuss with client (insurer) and reinsurers, the structure, conditions and the price of the reinsurance treaty- stand as an opposition to reinsurers during the price negotiation 2. Actuaries analyse, price and optimize reinsurance treaty, work on stochastic models for reinsurance program optimizations, spot market trends etc. 3. Cat management run catastrophic models (in-house models or third vendor models) on clients’ portfolios, test new models and their versions, made first estimate of cat losses on client portfolio just after the cat event 4. Model development team ( for Aon Benfield it is Impact Forecasting Team), works on development of catastrophic models 5. Client technical management team, administration of treaties (premium allocation, collection of recoveries etc.)

2 Topics

Introduction – Usual forms of Reinsurance vs. Non-Traditional Reinsurance Solution

1 Retroactive Reinsurance Solutions 2 Motivation for Retroactive Solutions 3 Adverse Development Cover ”out-of-the-money” 4 Loss Portfolio Transfer 5 Adverse Development Cover “in-the-money” 6 Pricing of ADC/LPT treaty

Case Study

3 Introduction – Traditional Reinsurance vs. Non- Traditional Reinsurance Solutions

4 Standard Products: Wrap-up

Quota Share – insurance company cedes the same percentage of losses and premium to reinsurer and receives commission, fixed cession/percentage

Surplus – insurance company cedes the same percentage of premium and losses, based on the sum insured in excess of deductible and receives commission, ratio differs for each risk

Excess of Loss (per risk or per event)- losses excess of deductible are recovered from reinsurer, fixed premium paid plus reinstatement premium, works on per loss basis

Stop Loss - losses excess of deductible (defined via loss ratio) recovered from reinsurer, fixed premium paid, works for accumulated losses per period

Aggregate Excess of Loss- the same as Stop Loss, deductible and limit are defined on monetary basis

*all the products are covered in detail e.g. in the presentation from 4th of December 2014 for CSaP 5 Reinsurance Products

Quota Share Surplus Aggregate covers

Stop Loss Excess of Loss

Treaty Negotiation Treaty Period Losses Occurrence

Contract Functionality Reinsurance contract covers future losses!

6 Reinsurance Products

Quota Share Surplus Aggregate covers

Stop Loss Excess of Loss

Losses Occurrence ???? ???

Retroactive Reinsurance Does reinsurance market provide solution for already incurred losses?

7 Section 1: Retroactive Reinsurance Solutions

8 Retroactive Reinsurance

Solutions for the risks associated with unresolved non-life liabilities of the insurance company. Solutions mainly used as a capital relief and/or BS & P&L stabilization.

Adverse Development Loss Portfolio Transfer Adverse Development Cover “Out of the Cover “In the Money” Money” LPT ADC ADC

Limit LimitLimit Limit

Attachment Point

Reserve Reserve Reserve Level Level Level Attachment Point Liabilities 0 Liabilities Liabilities 0 0

9 Section 2: Motivation for Retroactive Solutions

10 Business Strategy Capital Management

 Exit business line or  Regulator or rating market agency requirements for strengthening  Hibernation of capital positon alternative risk retaining entity such as captive  Stabilisation of profit and loss statement,  Finality in case of M&A protection against process adverse development in reserves

Key two drivers for ADC/LPT are reserve risk and timing risk (payment acceleration)

11 Reserve Risk Management

Loss Reserve EUR 100 mio

Predicted payments EUR 40 mio Predicted payments EUR 30 mio

Predicted Predicted payments payments EUR 15 mio EUR 15 mio

Year 0 Year 1 Year 2 Year 3 Year 4

Claims expected pay-out pattern of total reserves EUR 100 mio 12 Reserve Risk Management

Loss Reserve EUR 100 mio

Predicted payments EUR 40 mio Predicted payments EUR 30 mio

Predicted Predicted payments payments EUR 15 mio EUR 15 mio

Year 0 Year 1 Year 2 Year 3 Year 4

“Ring-fence” of liabilities in the troublesome portfolio 13 Section 3: Adverse Development Cover

14 Adverse Development Cover (ADC)

General principles

 This ADC is “out of the money” i.e. It attaches above the current claims reserves

 Paid claims in excess of a defined retention (Attachment Point) are ceded to the reinsurer, thus provides stop loss type protection Ultimate Loss  The reinsurer receives a premium payment

– Expected ceded technical provisions Limit – Plus volatility charge

– Scenario

Plus expenses/profit

Probability Probability loss for

Total Reinsurance Reinsurance Total

Implications Attachment Point -

 On day one, the technical provisions can be reduced to the retention Protection of the ADC, less a safety margin for the reinsurance default risk ADC Reserve Level Conclusion

 Using an ADC creates an upper threshold for cumulative claims payments and therefore, under IFRS, the technical provisions above the retention can be released immediately (less safety margin)

 The probability of exceeding the cover should be lower than the Liabilities required percentile (VaR, S&P or Solvency II) 0

15 Reserve Risk Management: Reserve Risk

Loss Reserve EUR 100 mio

Actual payment EUR 70 mio

Predicted payments EUR 40 mio Predicted payments EUR 30 mio

Predicted Predicted payments payments EUR 15 mio EUR 15 mio

Year 0 Year 1 Year 2 Year 3 Year 4  Cumulatively paid EUR 140 mio instead of EUR 100 mio  ADC “out of the money”, deductible 110 mio ADC attaching “out of the money” reduced reserve volatility and so claims settlement, additional amount paid is covered by reinsurer 16 Section 4: Loss Portfolio Transfer

17 Loss Portfolio Transfer (LPT)

General principles

 Protection is provided by a reinsurer for all claims from the ground up, subject to a limit which is set above the current reserve level

 100%(or less) reinsurance of the expected liabilities

 The reinsurer receives a premium payment

– Expected technical provisions

– Plus volatility charge Ultimate Loss

– Plus expenses/profit

. Very often contract is not for 100% (keep insurer involved in proper claim mng.) scenario Limit

. Usually commutation clause after couple of years Probability for loss loss for Probability . Profit commission can be used (tailored made for a contract)

Reserve Level

Implications –

 On day one, technical provisions can be reduced to the retention of the LPT (100%-x%) less a safety margin for reinsurance default risk LPT

 Credit risk associated with the reinsurer

 Some residual risk associated with burning through the whole programme –

some capital reserve will have to be retained Protection Reinsurance Total Liabilities Conclusion 0  Using an LPT transfers x% of the liability to a reinsurer and thereby reduces the exposure by the same percentage

 It is unlikely that the reinsurer would introduce a limit for traditional personal lines exposure

 Surplus in the technical provisions can be released immediately

18 Reserve Risk Management: Timing Risk

Loss Reserve EUR 100 mio

Actual payment EUR 55 mio

Predicted payments EUR 40 mio Predicted payments EUR 30 mio

Predicted Predicted payments paymentsPayment EUR 15 mio EUREUR 15 0mio

Year 0 Year 1 Year 2 Year 3 Year 4  Cumulatively still insurer pays EUR 100 mio  Acceleration in payment-pattern, in year 1 insurer should pay EUR 55 mio instead of EUR 40 mio expected

• LPT provides protection in case of ALM mismatch and timing risk • ALM and timing mismatch risk is ceded to reinsurer* *only cash operations 19 Section 5: Adverse Development Cover “in-the-money”

20 Blended LPT / ADC Solution

General principles

 This ADC is “in the money” i.e. It attaches below the current claims reserves and is in effect a blend of the traditional “out of the money” ADC and LPT models.

 Unlike the LPT, the reinsurance protection (the blue area) does not Ultimate Loss attach at 0 with this form of reinsurance.

 Premium will reflect the likelihood and magnitude of any likely Limit

deterioration of reserves.

Implications

 Premium will be higher than the “out of the money” ADC, given the higher volatility and greater likelihood of loss Reserve Level

 Protection

On day one, the technical provisions can be reduced to the retention Reinsurance Total

- of the ADC, less a safety margin for the reinsurance default risk Scenario

Attachment Point Probability loss Probability for

Conclusion ADC

 Using an ADC creates an upper threshold for cumulative claims payments and therefore, under IFRS, the technical provisions above the retention can be released immediately (less safety margin) Liabilities  The probability of exceeding the cover should be lower than the 0 required percentile (VaR, S&P or Solvency II)

21 Creativity without Borders (real example): ADC above LPT

General principles

 Protection is provided by a reinsurer, participating on LPT, for all claims from the ground up, subject to a limit which is set above/or at

the current reserve level Ultimate Loss

 100% reinsurance of the expected liabilities

 In case limit of LPT does not cover all liabilities ADC is in place ADC

 It is custom made solution so there is a potential to play around with

cost and limits and by this way possibility to save money

scenario Limit

Probability for loss loss for Probability

Reserve Level

Motivation –

 Client wants to split it, in that way (save money, diversified reinsurers LPT on the panel, use different broker, first put in place LTP and then decided to cover more.., etc. )

Total Reinsurance Protection Reinsurance Total Liabilities 0

22 Section 6: Pricing of ADC/LPT treaty

23 Key Pricing Steps for LTP/ADC

 Derivation of “best estimates” liabilities (chain ladder, Borhnuetter Ferguson etc.)

 Variability of reserves estimations (bootstrapping of triangles), important mainly for products with deductibles well above the “best estimates”

 Dependencies between classes, in case of more classes are transferred

 Discount factors (present value of the contract)

 Consideration of tax implication, cost of allocated capital, quality of data etc.

“Best estimates”, variability in reserves and discount factors are the main drivers of the price

24 Example of Reinsurers’ Quotes: standard property excess of loss (new program for insurer)

Huge variability in provided quotes

 Real example of property risk XL quotes from different reinsurers  ROL is monetary price divided by limit of the cover (here ROL for all layers)  Stretch almost 2% in ROL, means difference in price approximately EUR 1.5 mio

25 Case Study

26 Insurance Company: ABC

Line of Business: Motor Third Party Liability Underwriting Results: for years 2007 to 2011 loss ratio already above 100% Objective: reinsurance cover to protect future results’ volatility from legacy business and strengthen its capital position Size of technical provisions: EUR 50 mio

Retroactive reinsurance cover is suitable solution to protect future earnings against further reserve deterioration or rapid

settlements 27 Key Structuring Steps

1. ABC approached their broker with the aim of reserve risk reduction, mainly due the insufficient Solvency 2 ratio 2. After the discussion, broker identified 3 main possibilities and formulate data requirements 3. Data gathering and validation with the insurance company 4. Broker’s actuaries are analyzing data and structuring possible solutions  Proposal for structures and its features  Estimation of the price on reinsurance market  Identifying reinsurance market  Impact on solvency position 5. Solution proposed to the ABC 6. ABC decision about the desired solution and costs for such a solution 7. Broking company is negotiating the price with reinsurers 8. Final placement of the contract

28 Bootstrapping the triangles

• In order to structure reinsurance solutions we performed stochastic analysis of ultimate loss • With the help of bootstrapping technique we have obtained the distribution of ultimate net loss for underwriting years 2007-2011 net of specific reinsurance in given underwriting year

Distribution of ultimate unpaid loss net of reinsurance UWR 2007-2011 0.07 Mean (BE) 45,707,085

0.06 St.dev 8,968,093 Probability Incurred claims 0.05 Percentiles 99.0% 72,448,909 0.04 99.5% 76,162,049 99.6% 77,436,053 0.03 T-VAR 77,786,615 Simulations 0.02

0.01

22,900 25,700 28,400 31,200 33,900 36,700 39,500 42,200 45,000 47,700 50,500 53,300 56,000 58,800 61,500 64,300 67,100 69,800 72,600 75,400 78,100 80,900 83,600 86,400 89,200 3σ PLN, ths Probabilistic distribution of reserves is essential for reinsurance price estimation 29 Peter England and Richard Verrall's, Analytic and bootstrap estimates of prediction errors in claims reserving

ADC “Out of the Money”

Ultimate Loss Details of cover

• URW: 2007-2011 Limit • Limit: EUR 25 m • Limit corresponds to 3σ • Attachment Point: EUR 50 m • Attachment point at current

claims reserves vs BE EUR 45 Probability Probability loss Scenariofor Total Reinsurance Protection Protection Reinsurance Total mio

Attachment Point - • Expected reins. premium: EUR 4 m

(16% ROL) ADC ADC Reserve Level • Premium paid in cash

Liabilities 0

30 Pricing of the Proposed Reinsurance

• Pricing of the reinsurance highly depends on the individual reinsurers participating on the treaty • Broker determines best estimate of the price for two main reasons •To perform impact/profitability analysis of retroactive treaty •To have better position during negotiation with reinsurers

Price = (Risk Premium + Risk Margin + Cost of the Capital)

 Reinsurer needs to consider cost of the capital associated with such a deal  TVaR method to allocate capital

 Individual for each reinsurer  Depends on soft factors as reinsurance market conditions (soft etc,), quality of data, portfolio

 Average loss cost to the reinsurance program  Best estimates of reserves and its variability 31  Discounted according to the payment pattern ADC “Out of the Money” :PRICE

Price = (1,807,858+ 422,255+1,758,952) (= 3,989,064)

 2.5% interest rate  8% cost of capital applied on TVaR (1 in100)

 10% volatility charge (10% times standard deviation)

 Average losses to the layer

32 ADC “Out of the Money”

Reserves: 50,531,325 Best estimate: 45,707,085 Scenarios Example Deductible: 50,000,000

Actual Value of Result before Recoveries Result

Ultimate Loss Scenarios Payments ADC from ADC after ADC 1 50,531,325 0 531,325 - 3,468,675 2 45,707,085 4,824,240 - 824,240 Limit 3 60,000,000 - 9,468,675 10,000,000 - 3,468,675 4 30,000,000 20,531,325 - 16,531,325

5 … … …

Probability Probability loss Scenariofor Total Reinsurance Protection Protection Reinsurance Total Attachment Point  Result before ADC= Reserves-Actual Payments - 1st Scenario:50,531,325-50,531,325=0

ADC ADC  Recoveries from ADC= Payments above Reserve Level deductible 1st Scenario: max(50,531,325-50,000,000,0)=531,325  Result after ADC=Reserves-Actual Payments + Recoveries from ADC-Premium for ADC 1st Scenario: 50,531,325-50,531,325+531,325,- 4,000,000=-3,468,675

Liabilities 0

33 ADC “Out of the Money”

Before ADC After ADC OTM Reserves: 50,531,325 Best estimate: 45,707,085 mean 4,824,240 2,714,678 stdev 8,968,093 5,993,190 10.0% -6,460,539 -3,468,675

1.0% -21,917,584 -3,468,675 0.5% -25,630,724 -4,630,724 0.4% -26,904,728 -5,904,728 T-VAR 1 in 100 -27,255,290 -3,584,249

 Cover starts working from payments above EUR 50 mio EUR 50,531,325- EUR 50 ,000,000-4,000,000=-3,468,675 ADC provides stop loss type protection: losses from ceded portfolio will not cost more than reinsurance premium paid for the cover Hence this cover also decreases volatility of future profits34 ADC “In the Money”

Ultimate Loss Details of cover

Limit • URW: 2007-2011

• Limit: EUR 30 m

• corresponds to 3σ

• Attachment Point: EUR 45 m Reserve Level • Attachment point at current BE

Protection Protection EUR 45 mio

Total Reinsurance Reinsurance Total

- Scenario • Expected reins. premium: EUR 8 m

Attachment Point (26% ROL) Probability Probability loss for ADC ADC • Partially funds withheld, partially cash payment

Liabilities 0

35 ADC “In the Money” Reserves: 50,531,325 Best estimate: 45,707,085 Deductible: 45,000,000 Actual Result Ultimate Loss Value of before Recoveries Result after Scenarios Payments ADC from ADC ADC Limit 1.0 50,531,325 0 5,531,325 -2,468,675

2.0 45,707,085 4,824,240 707,085 -2,468,675

3.0 60,000,000 - 9,468,675 15,000,000 - 2,468,675

4.0 30,000,000 20,531,325 - 12,531,325

Reserve Level 5.0 … …

Protection Protection

Total Reinsurance Reinsurance Total

- Scenario  Result before ADC= Reserves-Actual Payments Attachment Point st

Probability Probability loss for 1 Scenario:50,531,325-50,531,325=0 ADC ADC  Recoveries from ADC= Payments above deductible 1st Scenario: max(50,531,325- Liabilities 0 45,000,000,0)=5,531,325  Result after ADC=Reserves-Actual Payments + Recoveries from ADC-Premium for ADC 1st Scenario: 50,531,325-50,531,325+5,531,325,- 8,000,000=-2,468,675

36 ADC “In the Money”

Before After ADC Reserves: 50,531,325 Best estimate: 45,707,085 ADC ITM Deductible: 45,000,000 mean 4,824,240 612,772 stdev 8,968,093 4,345,640 10.0% -6,460,539 -2,468,675 1.0% -21,917,584 -2,468,675 0.5% -25,630,724 -3,630,724 0.4% -26,904,728 -4,904,728 T-VAR 1 in 100 -27,255,290 -2,534,962

 Cover starts working from payments above EUR 45 mio EUR 50,531,32-EUR 45,000,000-8,000,000=-2,468,675 ADC “In the money” provide the same stop loss solution as ADC “out of the money” and better reduction in volatility but for higher price 37 Loss Portfolio Transfer

Ultimate Loss Details of cover

• URW: 2007-2011

scenario Limit • Limit: EUR 75 m

Probability for loss loss for Probability • Limit responds to BE + 3σ

Reserve Level • Attachment Point: EUR 0 m

– • Expected reins. premium: EUR 51 m

(26% ROL) LPT LPT •Funds withheld with partially cash

payment Total Reinsurance ProtectionReinsurance Total Liabilities 0

The direct impact of LPT is transfer of the whole reserve risk to reinsurer 38 Loss Portfolio Transfer

39 Case Study: SII

40 Solvency II and Reinsurance: Where does reinsurance play a role for non-life

Default risk of reinsurer

Non-Life premium risk

Non-Life reserve risk

Cat exposure risk

Diversification effects

41 Solvency II and Reinsurance: Wrap-up

Proportional Reinsurance-Standard Formula  Reduction of SCR proportional to cession amount e.g. Quota Share

50% cession, reduces SCRprem by 50% before diversification  longer term impact on future reserve risk

Non-Proportional reinsurance-Standard Formula  Capital requirement reduction by 20% for MTPL, Fire & Property and GTPL  0% for all other lines of business  Small risk mitigation via premium reduction

Risk adequate provision of non-proportional reinsurance possible only via Undertaking Specific Parameters or by Internal Model

42 Solvency II and Reinsurance: Retroactive Reinsurance

Loss Portfolio Transfer  Similar to Quota Share on prior year’s reserve risk, loss reserves ceded to reinsurance company  Reduction of SCR proportional to ceded reserves (100% LTP equivalent to 100% quota share)

Adverse Development Covers  Similar treatment as Excess of Loss covers  Standard formula does not recognize ADC  No reduction of reserves volume  No adjustment of reserve risk’s standard deviation

Risk adequate provision ADC possible only via Undertaking Specific Parameters or by Internal Model

43 Prospective and Retroactive Solutions

Reinsurance Type Standard Internal Model Formula

Quota Share   Surplus   Excess of Loss   Excess of Loss CAT   Stop Loss/Aggregate   LPT   ADC  

44 LPT: Solvency II Benefit

SCR, EUR ths Solvency II ratio 114,168 108%

-5,680 +11% 108,488 97%

Current With LPT Current With LPT  LPT cedes 100% of reserves to reinsurer, reduction of reserve risk before diversification

LPT solution also brings capital benefit in form of reduced SII capital requirement

Solvency Ratio=Available Capital/ Required Capital (SCR,required solvency margin) 45 Motivation of Accepting Reinsurance Company

Motivation of ceding company is straight forward and directly observable from our case study

Motivators of Accepting re/insurer

 Eventual profit

 Specialisations

 Liquidity

Example of big player on retroactive market Berkshire Hathaway . Number 5 in reinsurance market . NICO, is the entity that Berkshire primarily uses as the counterparty to its retroactive reinsurance transactions . Original amount reserved for the liabilities reinsured under its retroactive deals is USD 29.1 bil . Premium received USD 22.1 bil . NICO ‘s investments (total assets USD 127 bil) consist, 3.6% in bonds,53.3% in common stock, 34.8% in “other investments“, primary common stock equivalents

Berkshire Hathaway makes significant investment income on timing mismatch of upfront premium and losses paid later on.

**information published on Insurance Coverage Litigation Committee CLE Seminar March 2014, Tuscon USA, Berkshire Hathaway and Loss Portfolio Transfers: Do They Make Sense? 46 Thank you!

47 Aon Benfield